The Reddit Rampage
The markets have gone crazy again, at least on a small scale. A handful of stocks, known by some as Reddit stocks, have exhibited absolutely phenomenal performance as of late. You can see this below:
While the above is certainly not all of the impacted stocks, it includes the highlights and, of course, the poster child of this all, GameStop. This stock is up a massive 2,000%+ in very short order!
The Long & Short of It
What’s happening here that is driving the price up? The basics of it are there are two positions to take in markets. You can be long on a stock (buy it and hope it goes up) or short a stock (borrow the stock from someone, sell it at the current price hoping it goes down where you can buy it later at a lower price and return the shares you borrowed to the lender. You get to pocket the difference.). The ability to have two sides of a trade is one thing that can help with market efficiency by allowing different viewpoints to be expressed.
There has been a listing of some of the most heavily shorted stocks by hedge funds that have been in full view as of late. These hedge funds have taken short positions in stocks, thinking from a fundamental perspective these stocks should go down. On the other side, we have a community online of investors that have grouped together to target these massively shorted positions of hedge funds. They have either bought the stock outright or bought call options (the right to buy the stock at a future date at a price determined today). The result of this has been the power of numbers. Even though each of these individuals is small relative to institutional and hedge fund investors, banding together has created a massive impact.
This has led to a huge upswing in price based on circular logic. The social community buys, making the stock go up in value. The short investors then get forced to buy the stock at the higher price, making the stock go up even further. Why? Because the people who are shorting the position, betting the stock will go down, are “covering” their short positions. Essentially, they are losing a ton of money because these borrowed stocks are not going down in value as they had hoped, but instead up. Each time the stock goes up, they have the potential to lose an unlimited amount of money. To stop the bleeding, they have to buy the stock back even though the price is so much higher and their likely conviction in the stock going lower is higher than ever before.
What does this mean for you? Expect in the short-term some investors to be hit hard. Look at these same stocks this morning alone in the hour the market has been open as of this writing:
That is massive wealth destruction in a very short window. What’s more, is that many trading platforms have had temporary pauses in being able to execute trades. So, if you had a position where your investment timeframe may be minutes or hours, the access issue to a trade raises your risk even more.
More Volatility to Come
Expect more volatility within these stocks because these price movements are not driven by fundamentals of these companies but instead short-term market behavior, which can switch on a dime. Sometimes this is called the greater fool theory, where at some point, someone is left holding the bag before the price goes the opposite way you want it to – and goes hard. That could be starting today, or we could see an absolute resurgence in these names. Eventually, fundamentals will play out, but as the old saying goes, “Markets can stay irrational longer than you can stay solvent.”
For true long-term investors, this highlights a few things:
- Fundamentals do matter over time, yet you have to be patient. If your timeframe is too short, fundamentals mean nothing.
- Scrutiny is coming. This is likely going to grab the attention of regulators. It is also going to be of supreme focus for trading platforms and custodians. Making sure trades can happen whenever desired is and needs to be even more of a focal point.
- Being strategic yet nimble matters. With such rapid price movements, a couple of tools become helpful. The first is thinking about rebalancing horizons. If this, like it is for many individual investors, is annually, quarterly, or maybe even never, you miss out on price movement that can happen in shorter windows of time. Looking often to evaluate makes all the sense in the world. This is true within investment funds too. Indexes are great, yet they have certain constraints on when rebalancing and trading happens. Other passive approaches that combine the benefits of indexing (low cost, tax-efficient, staying diversified, and not making an investment bet) have the opportunity to adjust as market data and reality adjust.
While every situation in the market is unique and different this time, that’s the very thing about the markets that are not unique or different. Uncertainty exists, yet if there is a portfolio strategy in place that can confidently capture the eventual upward movement of the markets, stories like this on the Reddit stocks become an interesting thing, yet an uneventful one to your financial success story.
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